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The focus is on the interaction between demand and supply in a small open economy, featuring the dynamics of money wages,
private capital, public debtand foreign assets. A macroeconomic shock induces an extended process of adjustment that is characterized by unemployment. This in turn requires a dynamic path of monetary and fiscal policy.
As a response to the shock, the central bank continuously adapts the quantity of money so as to keep up full employment all the time. And the government continuously accommodates its purchases of goods and services. Can this be sustained? Or will public and foreign debt tend to explode, thereby squeezing private capital down to zero? As a finding, the answer depends on the government budget constraint, the exchange rate regime, the size of the foreign interest rate, the flexibility of money wages and other factors. The present monograph consists of two major parts, flexible exchange rates (part I) and fixed exchange rates (part II). Each part in turn is composed of two chapters, the basic model (chapter I) and the economy with public sector (chapter II).